Kitchen & Bath Design News is the industry's leading business, design and product resource for the kitchen and bath trade.
Issue link: http://kitchenbathdesign.epubxp.com/i/447551
26 | Kitchen & Bath Design News January 2015 T here are a number of ways to look at proft and how to go about managing profts and mar- gins in the kitchen and bath industry. Some of the terms associated with profit are net proft, gross proft, cost of sales, overhead and proft margin. Every time a business decision is made, it will have a specifc impact on some or all of these. In most cases the primary issue comes down to the bottom line, or net proft. We will begin by defn- ing gross and net proft and how these are determined. We will also examine how to view each of these concepts over the long term, as well as the short term. Finally, we will look at marginal cost/proft analysis and how to use this efectively with- out falling into its inherent pitfalls. FROM REVENUE TO PROFIT It's important not to confuse cash fow with proftability. While this seems obvious, it can be easy to ignore our accounting records if our business is awash in cash as a result of timing diferences between receiving revenue and having to actually pay out the associated costs. We mentioned the bot- tom line above, or more precisely, what is left after all costs and expenses are subtracted from the related revenues. For a business, the more complete and ac- curate defnition is that net proft (or loss) is the difer- ence between the business' net worth at the beginning of a period and the end of that period (net worth being defned as total assets minus total liabilities). While this defnition does provide the most accurate account of net results, it does not show how we got from point A to point B. An income statement will show us this by breaking down revenues, cost of sales and expenses. The cost of sales is considered to be di- rectly variable with revenues; that is, there is a direct re- lationship between revenues and the cost of producing those revenues. Cost of sales includes such items as mate- rials, job labor, etc. and the diference between revenues and cost of sales is defned as gross proft. Income statements should normally be produced on a monthly basis. In our busi- ness, cost of sales would also be broken down on a job by job basis with some form of job-costing system, since that is the level at which we are trying to control such costs. The topic of job costing is be- yond the scope of this article, so we will not delve into that at this time. The other class of costs are those that are relatively fxed in nature and usually referred to as operating ex- penses or overhead. Our object ive is to generate enough gross proft to cover all of our expenses and pro- duce a net proft. Let's look at a very simple example to illustrate our discussion: Revenues $200,000 Cost of Sales 120,000 Gross Proft 80,000 Overhead 70,000 Net Proft $ 10,000 A s su me t hat t he exa m- ple above represents one month's revenue and expens- es. It is likely that we could increase our sales revenue by $20,000 without having to increase our overhead. If your gross proft margin re- mained constant at 40%, this would produce an additional $8,000 net proft. Likewise, if your sales revenue fell $20,000, the net proft would fall by $8,000. In the short run, monthly variances in revenues will likely have some slight im- pact on overhead such as utilities and ofce payroll. Revenues can vary up or down considerably with- out any signifcant change i n such ex pen se s. O ver the longer term, increased sales activity will normally require an increase in such costs as additional stafng or overtime added to handle the increased administra- tive load. We conclude from this t hat t he term "f i xed ex- penses" really refers to a short-term situation and all expenses are variable over the longer haul. MARGINAL COST In Econ 101 we were taught that sellers will keep selling at lower and lower prices until the cost of producing that last sale equals the rev- enue it generates. Without getting lost in this discus- sion, we a re faced w it h similar situat ions in our businesses. Since we are in a business where each sale is for a dis- tinct "bundle of products and services," there is an element of negotiation involved and we must make an evaluation of what an acceptable gross proft percentage (margin) is. Further, since our revenues usually consist of a few large sales each month, we are in a position to view the impact of each additional sale on our business. If we assume that we have reached our normal monthly revenue of $200,000 and we have the opportunity to add one more $20,000 job if we are willing to take it on for 20% gross proft, it would make sense to do this. Since our overhead would likely only be slightly impacted, this would produce an ad- ditional net proft of almost $4,000. The process of evaluating each transaction as it is add- ed to total revenues to see if it results in more revenue than it costs to produce is referred to as marginal cost analysis. In theory, we would keep adding jobs until the cost of adding the last job equaled the revenue it pro- duced. This process would maximize our net proft. In reality, there is a trap hidden in this process. Competitive pressures will come to bear on the situation and our taking jobs from our competitors at less than normal mar- gins will probably cause them to respond by meeting our "marginal" pricing and thereby preventing us from doing our frst $200,000 of business each month at the 40% margins we had en- joyed. Even without actual competitive pressure, we will tend to let the margin on the last job sold infuence the margin we perceive pos- sible on the next one. If this strategy causes our margins to slip just 10% (from 40% to 30%), the revenue required to meet our overhead will increase by one third. And that as- sumes we don't have to add overhead to deal with the increased volume. T he poi nt here i s to c a r e f u l l y c o n s i d e r t h e longer-term implicat ions of reducing the price of a project in order to get the incremental profit that it might produce. If you are disciplined enough to add a job to your revenues oc- casionally by lowering the margin on only that job, it can be additional income for your business. It can also trigger some very unpleas- ant results if you do not fully understand the potential impact on your future pric- ing options or those of your competitors! "For a business, the net proft (or loss) is the diference between the business' net worth at the beginning of a period and the end of that period (net worth being defned as total assets minus total liabilities)." Tips for Managing Profts & Margins Understanding the diferent ways to look at proft and how to go about managing profts and margins will help your frm to become more proftable. Business Management { Bruce Kelleran, CKD, CPA } Read past columns and features and send us your comments about this article and others by logging onto our Web site: www.ForResidentialPros.com